Trade Costs and Export Decisions
Up to now, we have modeled economic integration as an increase in market size. This implicitly
assumes that this integration occurs to such an extent that a single combined market
is formed. In reality, integration rarely goes that far: Trade costs among countries are
reduced, but they do not disappear. In Chapter 2, we discussed how these trade costs are
manifested even for the case of the two very closely integrated economies of the United
States and Canada. We saw how the U.S.–Canada border substantially decreases trade volumes
between Canadian provinces and U.S. states.
Trade costs associated with this border crossing are also a salient feature of firm-level
trade patterns: Very few firms in the United States reach Canadian customers. In fact, most
U.S. firms do not report any exporting activity at all (because they sell only to U.S. customers).
In 2002, only 18 percent of U.S. manufacturing firms reported undertaking some
export sales. Table 8-3 shows the proportion of firms that report some export sales across
several different U.S. manufacturing sectors. Even in industries where exports represent a
substantial proportion of total production, such as chemicals, machinery, electronics, and
transportation, fewer than 40 percent of firms export. In fact, one major reason why trade
costs associated with national borders reduce trade so much is that they drastically cut
down the number of firms willing or able to reach customers across the border. (The other
reason is that the trade costs also reduce the export sales of firms that do reach those customers
across the border.)
In our integrated economy without any trade costs, firms were indifferent as to the location
of their customers. We now introduce trade costs to explain why firms actually do care
about the location of their customers, and why so many firms choose not to reach customers
in another country. As we will see shortly, this will also allow us to explain important
differences between those firms that choose to incur the trade costs and export, and
those that do not. Why would some firms choose not to export? Simply put, the trade costs
reduce the profitability of exporting for all firms. For some, that reduction in profitability
makes exporting unprofitable. We now formalize this argument.
To keep things simple, we will consider the response of firms in a world with two identical
countries (Home and Foreign). Let the market size parameter S now reflect the size of
each market, so that now reflects the size of the world market. We cannot analyze
this world market as a single market of size because this market is no longer
perfectly integrated due to trade costs.
2 * S
2 * S
TABLE 8-3 Proportion of U.S. Firms Reporting Export Sales by Industry, 2002
Printing 5%
Furniture 7%
Apparel 8%
Wood Products 8%
Fabricated Metals 14%
Petroleum and Coal 18%
Transportation Equipment 28%
Machinery 33%
Chemicals 36%
Computer and Electronics 38%
Electrical Equipment and Appliances 38%
Source: A. B. Bernard, J. B. Jensen, S. J. Redding, and P. K. Schott, “Firms in International Trade,”
Journal of Economic Perspectives 21 (Summer 2007), pp. 105–130.
CHAPTER 8 Firms in the Global Economy 177
Specifically, assume that a firm must incur an additional cost t for each unit of output
that it sells to customers across the border. We now have to keep track of the firms’ behavior
in each market separately. Due to the trade cost t, firms will set different prices in their
export market relative to their domestic market. This will lead to different quantities sold
in each market, and ultimately to different profit levels earned in each market. As each
firm’s marginal cost is constant (does not vary with production levels), those decisions regarding
pricing and quantity sold in each market can be separated: A decision regarding
the domestic market will have no impact on the profitability of different decisions for the
export market.
Consider the case of firms located in Home. Their situation regarding their domestic
(Home) market is exactly as was illustrated in Figure 8-6, except that all the outcomes,
such as price, output, and profit, relate to the domestic market only.15 Now consider the
decisions of firms 1 and 2 (with marginal costs and ) regarding the export (Foreign)
market. They face the same demand curve in Foreign as they do in Home (recall that we
assumed that the two countries are identical). The only difference is that the firms’ marginal
cost in the export market is shifted up by the trade cost t. Figure 8-8 shows the situation
for the two firms in both markets.
What are the effects of the trade cost on the firms’ decisions regarding the export market?
We know from our previous analysis that a higher marginal cost induces a firm to raise its
price, which leads to a lower output quantity sold and lower profits. We also know that
if marginal cost is raised above a threshold level , then a firm cannot profitably operate in
that market. This is what happens to firm 2 in Figure 8-8. Firm 2 can profitably operate in
c*
c1 c2
Cost, C and
Price, P
c2
c1
D
Quantity
MC2
MC1
(a) Domestic (Home) Market
c *
Cost, C and
Price, P
c2
c1
D
Quantity
c2 + t
c1 + t
c *
(b) Export (Foreign) Market
Figure 8-8
Export Decisions with Trade Costs
(a) Firms 1 and 2 both operate in their domestic (Home) market. (b) Only firm 1 chooses to export to the Foreign
market. It is not profitable for firm 2 to export given the trade cost t.
15The number of firms n is the total number of firms selling in the Home market. (This includes both firms
located in Home as well as the firms located in Foreign that export to Home). is the average price across all
those firms selling in Home.
P
178 PART ONE International Trade Theory
its domestic market, because its cost there is below the threshold: . However, it cannot
profitably operate in the export market because its cost there is above the threshold:
. Firm 1, on the other hand, has a low enough cost that it can profitably operate
in both the domestic and the export markets: . We can extend this prediction to
all firms based on their marginal cost . The lowest-cost firms with export; the
higher-cost firms with still produce for their domestic market but do not
export; the highest-cost firms with cannot profitably operate in either market, and
thus exit.
We just saw how the modeling of trade costs added two important predictions to our
model of monopolistic competition and trade: Those costs explain why only a subset of
firms export, and they also explain why this subset of firms will consist of relatively larger
and more productive firms (those firms with lower marginal cost ). Empirical analyses of
firms’ export decisions from numerous countries have provided overwhelming support for
this prediction that exporting firms are bigger and more productive than firms in the same
industry that do not export. In the United States in a typical manufacturing industry, an
exporting firm is on average more than twice as large as a firm that does not export. The
average exporting firm also produces 11 percent more value added (output minus intermediate
inputs) per worker than the average nonexporting firm. These differences across
exporters and nonexporters are even larger in many European countries.16
Up to now, we have modeled economic integration as an increase in market size. This implicitly
assumes that this integration occurs to such an extent that a single combined market
is formed. In reality, integration rarely goes that far: Trade costs among countries are
reduced, but they do not disappear. In Chapter 2, we discussed how these trade costs are
manifested even for the case of the two very closely integrated economies of the United
States and Canada. We saw how the U.S.–Canada border substantially decreases trade volumes
between Canadian provinces and U.S. states.
Trade costs associated with this border crossing are also a salient feature of firm-level
trade patterns: Very few firms in the United States reach Canadian customers. In fact, most
U.S. firms do not report any exporting activity at all (because they sell only to U.S. customers).
In 2002, only 18 percent of U.S. manufacturing firms reported undertaking some
export sales. Table 8-3 shows the proportion of firms that report some export sales across
several different U.S. manufacturing sectors. Even in industries where exports represent a
substantial proportion of total production, such as chemicals, machinery, electronics, and
transportation, fewer than 40 percent of firms export. In fact, one major reason why trade
costs associated with national borders reduce trade so much is that they drastically cut
down the number of firms willing or able to reach customers across the border. (The other
reason is that the trade costs also reduce the export sales of firms that do reach those customers
across the border.)
In our integrated economy without any trade costs, firms were indifferent as to the location
of their customers. We now introduce trade costs to explain why firms actually do care
about the location of their customers, and why so many firms choose not to reach customers
in another country. As we will see shortly, this will also allow us to explain important
differences between those firms that choose to incur the trade costs and export, and
those that do not. Why would some firms choose not to export? Simply put, the trade costs
reduce the profitability of exporting for all firms. For some, that reduction in profitability
makes exporting unprofitable. We now formalize this argument.
To keep things simple, we will consider the response of firms in a world with two identical
countries (Home and Foreign). Let the market size parameter S now reflect the size of
each market, so that now reflects the size of the world market. We cannot analyze
this world market as a single market of size because this market is no longer
perfectly integrated due to trade costs.
2 * S
2 * S
TABLE 8-3 Proportion of U.S. Firms Reporting Export Sales by Industry, 2002
Printing 5%
Furniture 7%
Apparel 8%
Wood Products 8%
Fabricated Metals 14%
Petroleum and Coal 18%
Transportation Equipment 28%
Machinery 33%
Chemicals 36%
Computer and Electronics 38%
Electrical Equipment and Appliances 38%
Source: A. B. Bernard, J. B. Jensen, S. J. Redding, and P. K. Schott, “Firms in International Trade,”
Journal of Economic Perspectives 21 (Summer 2007), pp. 105–130.
CHAPTER 8 Firms in the Global Economy 177
Specifically, assume that a firm must incur an additional cost t for each unit of output
that it sells to customers across the border. We now have to keep track of the firms’ behavior
in each market separately. Due to the trade cost t, firms will set different prices in their
export market relative to their domestic market. This will lead to different quantities sold
in each market, and ultimately to different profit levels earned in each market. As each
firm’s marginal cost is constant (does not vary with production levels), those decisions regarding
pricing and quantity sold in each market can be separated: A decision regarding
the domestic market will have no impact on the profitability of different decisions for the
export market.
Consider the case of firms located in Home. Their situation regarding their domestic
(Home) market is exactly as was illustrated in Figure 8-6, except that all the outcomes,
such as price, output, and profit, relate to the domestic market only.15 Now consider the
decisions of firms 1 and 2 (with marginal costs and ) regarding the export (Foreign)
market. They face the same demand curve in Foreign as they do in Home (recall that we
assumed that the two countries are identical). The only difference is that the firms’ marginal
cost in the export market is shifted up by the trade cost t. Figure 8-8 shows the situation
for the two firms in both markets.
What are the effects of the trade cost on the firms’ decisions regarding the export market?
We know from our previous analysis that a higher marginal cost induces a firm to raise its
price, which leads to a lower output quantity sold and lower profits. We also know that
if marginal cost is raised above a threshold level , then a firm cannot profitably operate in
that market. This is what happens to firm 2 in Figure 8-8. Firm 2 can profitably operate in
c*
c1 c2
Cost, C and
Price, P
c2
c1
D
Quantity
MC2
MC1
(a) Domestic (Home) Market
c *
Cost, C and
Price, P
c2
c1
D
Quantity
c2 + t
c1 + t
c *
(b) Export (Foreign) Market
Figure 8-8
Export Decisions with Trade Costs
(a) Firms 1 and 2 both operate in their domestic (Home) market. (b) Only firm 1 chooses to export to the Foreign
market. It is not profitable for firm 2 to export given the trade cost t.
15The number of firms n is the total number of firms selling in the Home market. (This includes both firms
located in Home as well as the firms located in Foreign that export to Home). is the average price across all
those firms selling in Home.
P
178 PART ONE International Trade Theory
its domestic market, because its cost there is below the threshold: . However, it cannot
profitably operate in the export market because its cost there is above the threshold:
. Firm 1, on the other hand, has a low enough cost that it can profitably operate
in both the domestic and the export markets: . We can extend this prediction to
all firms based on their marginal cost . The lowest-cost firms with export; the
higher-cost firms with still produce for their domestic market but do not
export; the highest-cost firms with cannot profitably operate in either market, and
thus exit.
We just saw how the modeling of trade costs added two important predictions to our
model of monopolistic competition and trade: Those costs explain why only a subset of
firms export, and they also explain why this subset of firms will consist of relatively larger
and more productive firms (those firms with lower marginal cost ). Empirical analyses of
firms’ export decisions from numerous countries have provided overwhelming support for
this prediction that exporting firms are bigger and more productive than firms in the same
industry that do not export. In the United States in a typical manufacturing industry, an
exporting firm is on average more than twice as large as a firm that does not export. The
average exporting firm also produces 11 percent more value added (output minus intermediate
inputs) per worker than the average nonexporting firm. These differences across
exporters and nonexporters are even larger in many European countries.16
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